This chapter introduces the institutional setting of over-the-counter (OTC) markets and raises some of the key conceptual issues associated with market opaqueness. An OTC market does not use a ...
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This chapter introduces the institutional setting of over-the-counter (OTC) markets and raises some of the key conceptual issues associated with market opaqueness. An OTC market does not use a centralized trading mechanism, such as an auction, specialist, or limit-order book, to aggregate bids and offers and to allocate trades. Instead, buyers and sellers negotiate terms privately, often in ignorance of the prices currently available from other potential counterparties and with limited knowledge of trades recently negotiated elsewhere in the market. OTC markets are thus said to be relatively opaque; investors are somewhat in the dark about the most attractive available terms and about whom to contact for attractive terms. Prices and allocations in OTC markets are, to varying extents, influenced by opaqueness and by the role of intermediating brokers and dealers.Less

Over-the-Counter Markets

Darrell Duffie

Published in print: 2012-01-08

This chapter introduces the institutional setting of over-the-counter (OTC) markets and raises some of the key conceptual issues associated with market opaqueness. An OTC market does not use a centralized trading mechanism, such as an auction, specialist, or limit-order book, to aggregate bids and offers and to allocate trades. Instead, buyers and sellers negotiate terms privately, often in ignorance of the prices currently available from other potential counterparties and with limited knowledge of trades recently negotiated elsewhere in the market. OTC markets are thus said to be relatively opaque; investors are somewhat in the dark about the most attractive available terms and about whom to contact for attractive terms. Prices and allocations in OTC markets are, to varying extents, influenced by opaqueness and by the role of intermediating brokers and dealers.

Over-the-counter (OTC) markets for derivatives, collateralized debt obligations, and repurchase agreements played a significant role in the global financial crisis. Rather than being traded through a ...
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Over-the-counter (OTC) markets for derivatives, collateralized debt obligations, and repurchase agreements played a significant role in the global financial crisis. Rather than being traded through a centralized institution such as a stock exchange, OTC trades are negotiated privately between market participants who may be unaware of prices that are currently available elsewhere in the market. In these relatively opaque markets, investors can be in the dark about the most attractive available terms and who might be offering them. This opaqueness exacerbated the financial crisis, as regulators and market participants were unable to quickly assess the risks and pricing of these instruments. This book offers a concise introduction to OTC markets by explaining key conceptual issues and modeling techniques, and by providing readers with a foundation for more advanced subjects in this field. The book covers the basic methods for modeling search and random matching in economies with many agents. It gives an overview of asset pricing in OTC markets with symmetric and asymmetric information, showing how information percolates through these markets as investors encounter each other over time. The book also features appendixes containing methodologies supporting the more theory-oriented of the chapters, making this the most self-contained introduction to OTC markets available.Less

Darrell Duffie

Published in print: 2012-01-08

Over-the-counter (OTC) markets for derivatives, collateralized debt obligations, and repurchase agreements played a significant role in the global financial crisis. Rather than being traded through a centralized institution such as a stock exchange, OTC trades are negotiated privately between market participants who may be unaware of prices that are currently available elsewhere in the market. In these relatively opaque markets, investors can be in the dark about the most attractive available terms and who might be offering them. This opaqueness exacerbated the financial crisis, as regulators and market participants were unable to quickly assess the risks and pricing of these instruments. This book offers a concise introduction to OTC markets by explaining key conceptual issues and modeling techniques, and by providing readers with a foundation for more advanced subjects in this field. The book covers the basic methods for modeling search and random matching in economies with many agents. It gives an overview of asset pricing in OTC markets with symmetric and asymmetric information, showing how information percolates through these markets as investors encounter each other over time. The book also features appendixes containing methodologies supporting the more theory-oriented of the chapters, making this the most self-contained introduction to OTC markets available.

This chapter shows how the intraday allocation and pricing of overnight loans of federal funds reflect the over-the-counter interbank market in which these loans are traded. It provides estimates of ...
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This chapter shows how the intraday allocation and pricing of overnight loans of federal funds reflect the over-the-counter interbank market in which these loans are traded. It provides estimates of how the likelihood that some bank i borrows from some other bank j during a particular minute t of a business day, as well as the interest rate on the loan, depend on the prior trading relationship between these two banks, the extents to which their balances at the beginning of minute t are above or below their normal respective balances for that time of day, their overall levels of trading activities, the amount of time left until their end-of-day balances are monitored for reserve-requirement purposes, and the volatility of the federal funds rate in the trailing 30 minutes.Less

The Case of Federal Funds Lending

Darrell Duffie

Published in print: 2012-01-08

This chapter shows how the intraday allocation and pricing of overnight loans of federal funds reflect the over-the-counter interbank market in which these loans are traded. It provides estimates of how the likelihood that some bank i borrows from some other bank j during a particular minute t of a business day, as well as the interest rate on the loan, depend on the prior trading relationship between these two banks, the extents to which their balances at the beginning of minute t are above or below their normal respective balances for that time of day, their overall levels of trading activities, the amount of time left until their end-of-day balances are monitored for reserve-requirement purposes, and the volatility of the federal funds rate in the trailing 30 minutes.

This chapter presents a simple introduction to asset pricing in over-the-counter markets. Investors search for opportunities to trade and bargain with counterparties, each counterparty being aware ...
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This chapter presents a simple introduction to asset pricing in over-the-counter markets. Investors search for opportunities to trade and bargain with counterparties, each counterparty being aware that failure to conduct a trade could lead to a costly new search for a counterparty. In equilibrium, whenever there is gain from trade, the opportunity to search for a new counterparty is dominated by trading at the equilibrium asset price. The asset price reflects the degree of search frictions. Under conditions, illiquidity premia are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, and when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then “recover” over time, with a pattern that depends on the degree of search frictions. The chapter shows how the equilibrium bargaining powers of the counterparties are determined by search opportunities using the approach of Rubinstein and Wolinsky (1985).Less

A Simple OTC Pricing Model

Darrell Duffie

Published in print: 2012-01-08

This chapter presents a simple introduction to asset pricing in over-the-counter markets. Investors search for opportunities to trade and bargain with counterparties, each counterparty being aware that failure to conduct a trade could lead to a costly new search for a counterparty. In equilibrium, whenever there is gain from trade, the opportunity to search for a new counterparty is dominated by trading at the equilibrium asset price. The asset price reflects the degree of search frictions. Under conditions, illiquidity premia are higher when counterparties are harder to find, when sellers have less bargaining power, when the fraction of qualified owners is smaller, and when risk aversion, volatility, or hedging demand is larger. Supply shocks cause prices to jump, and then “recover” over time, with a pattern that depends on the degree of search frictions. The chapter shows how the equilibrium bargaining powers of the counterparties are determined by search opportunities using the approach of Rubinstein and Wolinsky (1985).

This chapter describes a simple model of the “percolation” of information of common interest through an over-the-counter market with many agents. It also includes an explicit solution for the ...
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This chapter describes a simple model of the “percolation” of information of common interest through an over-the-counter market with many agents. It also includes an explicit solution for the cross-sectional distribution of posterior beliefs at each time. It begins with the basic information structure for the economy and the setting for search and random matching. It then shows how to solve the model for the dynamics of the cross-sectional distribution of information. The remainder of the chapter is devoted to market settings and to extensions of the model that handle public releases of information, the receipt of new private information over time, and the release of information among groups of more than two agents at a time.Less

Information Percolation in OTC Markets

Darrell Duffie

Published in print: 2012-01-08

This chapter describes a simple model of the “percolation” of information of common interest through an over-the-counter market with many agents. It also includes an explicit solution for the cross-sectional distribution of posterior beliefs at each time. It begins with the basic information structure for the economy and the setting for search and random matching. It then shows how to solve the model for the dynamics of the cross-sectional distribution of information. The remainder of the chapter is devoted to market settings and to extensions of the model that handle public releases of information, the receipt of new private information over time, and the release of information among groups of more than two agents at a time.

This chapter introduces the modeling of search and random matching in large economies. The objective is to build intuition and techniques for later chapters. After some mathematical prerequisites, it ...
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This chapter introduces the modeling of search and random matching in large economies. The objective is to build intuition and techniques for later chapters. After some mathematical prerequisites, it defines the notion of random matching. It then invokes the law of large numbers to calculate the cross-sectional distribution of types of matches. This is extended to multiperiod search, first in discrete-time settings and then in continuous time. The optimal search intensity of a given agent, given the cross-sectional distribution of types in the population, is characterized with Bellman's principle. The chapter then briefly takes up the issue of equilibrium search efforts.Less

Search for Counterparties

Darrell Duffie

Published in print: 2012-01-08

This chapter introduces the modeling of search and random matching in large economies. The objective is to build intuition and techniques for later chapters. After some mathematical prerequisites, it defines the notion of random matching. It then invokes the law of large numbers to calculate the cross-sectional distribution of types of matches. This is extended to multiperiod search, first in discrete-time settings and then in continuous time. The optimal search intensity of a given agent, given the cross-sectional distribution of types in the population, is characterized with Bellman's principle. The chapter then briefly takes up the issue of equilibrium search efforts.

This chapter expounds on the notion of the liquidity of an asset and its ability to function as a medium of exchange. Here, trading frictions are not associated with the purchase and consumption of ...
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This chapter expounds on the notion of the liquidity of an asset and its ability to function as a medium of exchange. Here, trading frictions are not associated with the purchase and consumption of goods. Instead, these are introduced into an asset market, or an over-the-counter market, with bilateral matches between investors and dealers. This model is further explored in an economy where investors accumulate capital goods to produce a general consumption good. Trading fictions are also endogenized by accepting free entry of dealers in the market-making sector. The chapter shows that multiple equilibria is reached due to the presence of complementarities between investors’ asset-holding decisions and dealers’ entry decisions, leading to the drying up of liquidity in the market because of self-fulfilling beliefs.Less

Liquidity and Trading Frictions

Ed NosalGuillaume Rocheteau

Published in print: 2011-10-28

This chapter expounds on the notion of the liquidity of an asset and its ability to function as a medium of exchange. Here, trading frictions are not associated with the purchase and consumption of goods. Instead, these are introduced into an asset market, or an over-the-counter market, with bilateral matches between investors and dealers. This model is further explored in an economy where investors accumulate capital goods to produce a general consumption good. Trading fictions are also endogenized by accepting free entry of dealers in the market-making sector. The chapter shows that multiple equilibria is reached due to the presence of complementarities between investors’ asset-holding decisions and dealers’ entry decisions, leading to the drying up of liquidity in the market because of self-fulfilling beliefs.

This chapter provides a discussion of private and public governance by considering how private legal technique might translate into new public governance methods. The debate on the proper ...
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This chapter provides a discussion of private and public governance by considering how private legal technique might translate into new public governance methods. The debate on the proper relationship between the state and the market, and regarding the optimal design of regulatory institutions, often turn on assumptions about the workings of legal expertise—and in particular about the difference between public expertise and private expertise. This chapter takes on Hayekian arguments against government regulation through a detailed examination of real-world examples of how public and private legal technologies manage the temporal dimensions of risk in the over-the-counter (OTC) derivatives markets. Hayek's description of the limitations of bureaucratic planning resonates with the sense of powerlessness and frustration experienced by many government officials as they attempt to manage economic fluctuations. But Hayek's account of the limits of well-meaning public legal expertise is far less complete when it comes to the strengths of private legal reasoning. Public reasoning has temporal weaknesses, so private reasoning must have equivalent temporal strengths. In order to understand the root of this legitimacy gap, the chapter considers how collateral, as a private legal technology, handles the temporal uncertainties surrounding market risk.Less

Placeholders: Engaging the Hayekian Critique of Financial Regulation

Annelise Riles

Published in print: 2011-05-01

This chapter provides a discussion of private and public governance by considering how private legal technique might translate into new public governance methods. The debate on the proper relationship between the state and the market, and regarding the optimal design of regulatory institutions, often turn on assumptions about the workings of legal expertise—and in particular about the difference between public expertise and private expertise. This chapter takes on Hayekian arguments against government regulation through a detailed examination of real-world examples of how public and private legal technologies manage the temporal dimensions of risk in the over-the-counter (OTC) derivatives markets. Hayek's description of the limitations of bureaucratic planning resonates with the sense of powerlessness and frustration experienced by many government officials as they attempt to manage economic fluctuations. But Hayek's account of the limits of well-meaning public legal expertise is far less complete when it comes to the strengths of private legal reasoning. Public reasoning has temporal weaknesses, so private reasoning must have equivalent temporal strengths. In order to understand the root of this legitimacy gap, the chapter considers how collateral, as a private legal technology, handles the temporal uncertainties surrounding market risk.